Transcript

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Finance 1
Finance
Finance is often defined simply as the management of money or “funds” management.
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Modern finance, however,
is a family of business activity that includes the origination, marketing, and management of cash and money
surrogates through a variety of capital accounts, instruments, and markets created for transacting and trading assets,
liabilities, and risks. Finance is conceptualized, structured, and regulated by a complex system of power relations
within political economies across state and global markets. Finance is both art (e.g. product development) and
science (e.g. measurement), although these activities increasingly converge through the intense technical and
institutional focus on measuring and hedging risk-return relationships that underlie shareholder value. Networks of
financial businesses exist to create, negotiate, market, and trade in evermore-complex financial products and services
for their own as well as their clients’ accounts. Financial performance measures assess the efficiency and profitability
of investments, the safety of debtors’ claims against assets, and the likelihood that derivative instruments will protect
investors against a variety of market risks.
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The financial system consists of public and private interests and the markets that serve them. It provides capital from
individual and institutional investors who transfer money directly and through intermediaries (e.g. banks, insurance
companies, brokerage and fund management firms) to other individuals, firms, and governments that acquire
resources and transact business. With the expectation of reaping profits, investors fund credit in the forms of (1) debt
capital (e.g. corporate and government notes and bonds, mortgage securities and other credit instruments), (2) equity
capital (e.g. listed and unlisted company shares), and (3) the derivative products of a wide variety of capital
investments including debt and equity securities, property, commodities, and insurance products. Although closely
related, the disciplines of economics and finance are distinctive. The “economy” is a social institution that organizes
a society’s production, distribution, and consumption of goods and services,” all of which must be financed.
Economists make a number of abstract assumptions for purposes of their analyses and predictions. They generally
regard financial markets that function for the financial system as an efficient mechanism. In practice, however,
emerging research is demonstrating that such assumptions are unreliable. Instead, financial markets are subject to
human error and emotion.
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New research discloses the mischaracterization of investment safety and measures of
financial products and markets so complex that their effects, especially under conditions of uncertainty, are
impossible to predict. The study of finance is subsumed under economics as finance economics, but the scope, speed,
power relations and practices of the financial system can uplift or cripple whole economies and the well-being of
households, businesses and governing bodies within them—sometimes in a single day.
Three overarching divisions exist within the academic discipline of finance and its related practices: 1) personal
finance: the finances of individuals and families concerning household income and expenses, credit and debt
management, saving and investing, and income security in later life, 2) corporate finance: the finances of for-profit
organizations including corporations, trusts, partnerships and other entities, and 3) public finance: the financial
affairs of domestic and international governments and other public entities.
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Areas of study within (and the
interactions among) these three levels affect all dimensions of social life: politics, taxes, art, religion, housing, health
care, poverty and wealth, consumption, sports, transportation, labor force participation, media, and education. While
each has a vast accumulated literature of its own, the effects of macro and micro level financing that mold and
impact these and other domains of human and societal life typically have been treated by researchers as “policy,”
“welfare,” “work,” “stratification,” and so forth, or have been largely unexplored. Recent research in "behavioral
finance" is promising, albeit a relative newcomer, to the existing body of financial research that focuses primarily on
measurement.
Loans have become increasingly packaged for resale, meaning that an investor buys the loan (debt) from a bank or
directly from a corporation. Bonds are debt instruments sold to investors for organizations such as companies,
governments or charities.
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The investor can then hold the debt and collect the interest or sell the debt on a
secondary market. Banks are the main facilitators of funding through the provision of credit, although private equity,

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Finance 2
mutual funds, hedge funds, and other organizations have become important as they invest in various forms of debt.
Financial assets, known as investments, are financially managed with careful attention to financial risk management
to control financial risk. Financial instruments allow many forms of securitized assets to be traded on securities
exchanges such as stock exchanges, including debt such as bonds as well as equity in publicly traded corporations.
Central banks, such as the Federal Reserve System banks in the United States and Bank of England in the United
Kingdom, are strong players in public finance, acting as lenders of last resort as well as strong influences on
monetary and credit conditions in the economy.
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Overview of techniques and sectors of the financial industry
An entity whose income exceeds its expenditure can lend or invest the excess income. On the other hand, an entity
whose income is less than its expenditure can raise capital by borrowing or selling equity claims, decreasing its
expenses, or increasing its income. The lender can find a borrower, a financial intermediary such as a bank, or buy
notes or bonds in the bond market. The lender receives interest, the borrower pays a higher interest than the lender
receives, and the financial intermediary earns the difference for arranging the loan.
A bank aggregates the activities of many borrowers and lenders. A bank accepts deposits from lenders, on which it
pays interest. The bank then lends these deposits to borrowers. Banks allow borrowers and lenders, of different sizes,
to coordinate their activity.
Finance is used by individuals (personal finance), by governments (public finance), by businesses (corporate
finance) and by a wide variety of other organizations, including schools and non-profit organizations. In general, the
goals of each of the above activities are achieved through the use of appropriate financial instruments and
methodologies, with consideration to their institutional setting.
Finance is one of the most important aspects of business management and includes decisions related to the use and
acquisition of funds for the enterprise.
In corporate finance, a company's capital structure is the total mix of financing methods it uses to raise funds. One
method is debt financing, which includes bank loans and bond sales. Another method is equity financing - the sale of
stock by a company to investors, the original shareholders of a share. Ownership of a share gives the shareholder
certain contractual rights and powers, which typically include the right to receive declared dividends and to vote the
proxy on important matters (e.g., board elections). The owners of both bonds and stock, may be institutional
investors - financial institutions such as investment banks and pension funds — or private individuals, called private
investors or retail investors.
Areas of finance
Personal finance
Questions in personal finance revolve around
• How much money will be needed by an individual (or by a family), and when?
• How can people protect themselves against unforeseen personal events, as well as those in the external economy?
• How can family assets best be transferred across generations (bequests and inheritance)?
• How does tax policy (tax subsidies or penalties) affect personal financial decisions?
• How does credit affect an individual's financial standing?
• How can one plan for a secure financial future in an environment of economic instability?
Personal financial decisions may involve paying for education, financing durable goods such as real estate and cars,
buying insurance, e.g. health and property insurance, investing and saving for retirement.
Personal financial decisions may also involve paying for a loan, or debt obligations.

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Finance 3
Corporate finance
Managerial or corporate finance is the task of providing the funds for a corporation's activities (for small business,
this is referred to as SME finance). Corporate finance generally involves balancing risk and profitability, while
attempting to maximize an entity's wealth and the value of its stock, and generically entails three interrelated
decisions. In the first, "the investment decision", management must decide which "projects" (if any) to undertake.
The discipline of capital budgeting is devoted to this question, and may employ standard business valuation
techniques or even extend to real options valuation; see Financial modeling. The second, "the financing decision"
relates to how these investments are to be funded: capital here is provided by shareholders, in the form of equity
(privately or via an initial public offering), creditors, often in the form of bonds, and the firm's operations (cash
flow). Short-term funding or working capital is mostly provided by banks extending a line of credit. The balance
between these elements forms the company's capital structure. The third, "the dividend decision", requires
management to determine whether any unappropriated profit is to be retained for future investment / operational
requirements, or instead to be distributed to shareholders, and if so in what form. Short term financial management is
often termed "working capital management", and relates to cash-, inventory- and debtors management. These areas
often overlap with the firm's accounting function, however, financial accounting is more concerned with the
reporting of historical financial information, while these financial decisions are directed toward the future of the
firm.
Finance of public entities
Public finance describes finance as related to sovereign states and sub-national entities (states/provinces, counties,
municipalities, etc.) and related public entities (e.g. school districts) or agencies. It is concerned with:
• Identification of required expenditure of a public sector entity
• Source(s) of that entity's revenue
• The budgeting process
• Debt issuance (municipal bonds) for public works projects
Financial risk management
Financial risk management is the practice of creating and protecting economic value in a firm by using financial
instruments to manage exposure to risk, particularly credit risk and market risk. (Other risk types include Foreign
exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc.) It focuses on when and how to hedge using
financial instruments; in this sense it overlaps with financial engineering. Similar to general risk management,
financial risk management requires identifying its sources, measuring it (see: Risk measure: Well known risk
measures), and formulating plans to address these, and can be qualitative and quantitative. In the banking sector
worldwide, the Basel Accords are generally adopted by internationally active banks for tracking, reporting and
exposing operational, credit and market risks.
Finance theory
Financial economics
Financial economics is the branch of economics studying the interrelation of financial variables, such as prices,
interest rates and shares, as opposed to those concerning the real economy. Financial economics concentrates on
influences of real economic variables on financial ones, in contrast to pure finance. It centres on decision making
under uncertainty in the context of the financial markets, and the resultant economic and financial models. It
essentially explores how rational investors would apply decision theory to the problem of investment. Here, the twin
assumptions of rationality and market efficiency lead to modern portfolio theory (the CAPM), and to the Black
Scholes theory for option valuation; it further studies phenomena and models where these assumptions do not hold,

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Finance 4
or are extended. "Financial economics", at least formally, also considers investment under "certainty" (Fisher
separation theorem, "theory of investment value", Modigliani-Miller theorem) and hence also contributes to
corporate finance theory. Financial Econometrics is the branch of Financial Economics that uses econometric
techniques to parameterize the relationships suggested.
Financial mathematics
Financial mathematics is a field of applied mathematics, concerned with financial markets. The subject has a close
relationship with the discipline of financial economics, which is concerned with much of the underlying theory.
Generally, mathematical finance will derive, and extend, the mathematical or numerical models suggested by
financial economics. In terms of practice, mathematical finance also overlaps heavily with the field of computational
finance (also known as financial engineering). Arguably, these are largely synonymous, although the latter focuses
on application, while the former focuses on modeling and derivation (see: Quantitative analyst). The field is largely
focused on the modelling of derivatives, although other important subfields include insurance mathematics and
quantitative portfolio problems. See Outline of finance: Mathematical tools; Outline of finance: Derivatives pricing.
Experimental finance
Experimental finance aims to establish different market settings and environments to observe experimentally and
provide a lens through which science can analyze agents' behavior and the resulting characteristics of trading flows,
information diffusion and aggregation, price setting mechanisms, and returns processes. Researchers in experimental
finance can study to what extent existing financial economics theory makes valid predictions, and attempt to
discover new principles on which such theory can be extended. Research may proceed by conducting trading
simulations or by establishing and studying the behaviour of people in artificial competitive market-like settings.
Behavioral finance
Behavioral Finance studies how the psychology of investors or managers affects financial decisions and markets.
Behavioral finance has grown over the last few decades to become central to finance.
Behavioral finance includes such topics as:
1. Empirical studies that demonstrate significant deviations from classical theories.
2. Models of how psychology affects trading and prices
3. Forecasting based on these methods.
4. Studies of experimental asset markets and use of models to forecast experiments.
A strand of behavioral finance has been dubbed Quantitative Behavioral Finance, which uses mathematical and
statistical methodology to understand behavioral biases in conjunction with valuation. Some of this endeavor has
been led by Gunduz Caginalp (Professor of Mathematics and Editor of Journal of Behavioral Finance during
2001-2004) and collaborators including Vernon Smith (2002 Nobel Laureate in Economics), David Porter, Don
Balenovich, Vladimira Ilieva, Ahmet Duran). Studies by Jeff Madura, Ray Sturm and others have demonstrated
significant behavioral effects in stocks and exchange traded funds. Among other topics, quantitative behavioral
finance studies behavioral effects together with the non-classical assumption of the finiteness of assets.